If you find tax-free savings accounts (TFSAs) a bit confusing, you should direct some of the blame at whoever came up with the name. While they are labeled a type of savings account, TFSAs are much more than that: once you understand how they work and how to optimize them, they can serve as a powerful tool in your overall financial plan.
Below, we shine a spotlight on the dos, don’ts and potential of TFSAs so that you can use yours to drive serious financial growth.
Investing, not saving
First things first: a TFSA is no place for cash or low-interest money market investments. Banks have done a great job marketing TFSAs as a type of secondary savings account, but using them in this way is rather pointless.
With a TFSA, the basic premise is that you pay tax on money before putting it into the account, but not on money within or coming out of the account. This means that any growth of investments within a TFSA – whether from capital gains or dividends – is tax free.
If you have savings earning 1% interest per year, the impact of this tax shelter is minimal. On the other hand, if you have investments compounding at 10% per year, the potential for long-term tax savings is huge.
Putting your TFSA to work
TFSAs are a relatively new addition to the financial landscape in Canada, having been launched only in 2009, yet many Canadians have wasted no time in harnessing their potential. If you need inspiration, check out this article on building a $1 million TFSA, which some people have already achieved within just a few short years.
Reaching $1 million in a TFSA is not a realistic short-term goal for most of us, but you can certainly achieve significant growth. How? By choosing growth-oriented investments while taking into account your risk appetite.
Subject to some restrictions (see below), stocks, bonds and exchange-traded funds (ETFs) are all eligible investments for a TFSA. As are mutual funds and other managed products. All of these instruments have the potential to produce attractive returns well beyond the virtually non-existent interest paid on savings held by a bank.
Even if you are nearing retirement age and seeking lower-risk investments, opting for guaranteed investment certificates (GICs) and term deposits will still give you a few percentage points of annual growth – better than parking cash in your TFSA.
Playing by the rules
Before you rush off to open a TFSA or make sweeping changes if you already have one, here are some important guidelines to help you make the most of your account while steering clear of trouble:
- Contribution room. There are strict limits on how much you can contribute per year to your TFSA. For 2017, the limit is $5,500; unused contribution room from previous years is carried forward. However, if you exceed your contribution room at any point during the year, you will be hit with a penalty of 1% per month on the excess contribution. You can find out your current contribution room by contacting Canada Revenue Agency (CRA) or by logging into your CRA account online.
- Withdrawals. The good news: you can withdraw money from your TFSA at any time, although the liquidity of the withdrawal will depend on how the funds were invested. The bad news: withdrawals do not increase your contribution room until the following year. For example, if you currently have $5,500 in contribution room for 2017 and proceed to withdraw $10,000 from your TFSA, your contribution room will remain at $5,500 for 2017 while the $10,000 withdrawal will be added to your contribution room for 2018.
- Permissible investments. As explained above, a TFSA can hold a wide range of financial instruments and should be viewed as an investment account rather than a savings account. That said, there are some restrictions on the types of investments permitted. For example, any securities in a TFSA must be listed on a designated stock exchange. In addition, shares of a small business corporation can be held within a TFSA in some situations, but not all.
As long as you follow the rules, TFSAs are great way to grow your investment portfolio on a tax-free basis. For a more detailed look at the ins and out of TFSAs, check out the latest information from CRA or speak with your financial advisor.
Confusion regarding TFSAs remains widespread, but one thing is clear: use your TFSA as a piggy bank and you’re going to be disappointed; use it as a tax shelter for high-growth investments and you’ll be opening the door to significant potential gains and tax savings over the long term